The market crash has given us some stocks which really seem too cheap for what they have to offer, this definitely seems to be one of these..

Take a company which:

• Has remarkable and steady profitability growth (2004: $0.34 per share, 2008: $1.32 per share)
• Is situated in a very large market (China), with ample growth opportunities
• Has plenty of strategic tricks left to beat the market growth
• Has a savy strategy and the means to execute it
• Is really incredibly cheap (trailing p/e of 4, peg ratio of 0.18)

We’re reading the year-end (2008) report from such a company, Fuqi International. What do they do? They’re in the business of designing, developing, promoting, and selling of precious metal jewellery in the People’s Republic of China. Here are some main themes:

The Market’s ample growth opportunities

Even in a terrible world market, the Chinese economy is expected to grow by some 6% this year, and be among the first to recover from the deep world recession. We also know a couple of things:

• The middle class is growing at a torrent pace
• In Asia, the ‘bling-bling’ factor is pretty significant. Conspicuous consumption in general, and gold an jewelry in particular are almost forms of liberation after generations of poverty and Communist inspired frugality and uniformity.
• The jewellery industry in China has grown at an annual rate of approximately 10 percent since the 1980’s and is expected to be the largest market in the world by 2010.  In 2005, domestic sales of jewellery in China amounted to RMB 140 billion, which is approximately US$19.8 billion, and the industry earned $5.49 billion worth of foreign exchange for China through exports.  In 2008, the growth in China’s jewellery industry was higher than its general economic growth. As a result, China became the second largest gold consumer and the largest platinum jewellery market in the world.

Strategies to expand even faster

1) Aggressively pursue new wholesale distribution channels

• This is just expanding on their current business model.

2) Move from wholesale to retail

• At present, all but $11 million of their sales ($367.471 million) are wholesale’s, that is selling to other retail outlets. Retail sales, which are higher margin, comprise just 3%, but this is going to chance
• During 2008, we opened and/or acquired 56 retail counters and acquired seven retail stores in municipalities and provincial capitals throughout China. A majority of these retail locations were acquired in August 2008, when we acquired substantially all of the assets of the Temix Companies. 6p26
• On August 7, 2008, we acquired substantially all of the assets of Shanghai Tian Mei Jewelry Co., Ltd. and Beijing Yinzhong Tian Mei Jewelry Co., Ltd., collectively referred to as the “Temix Companies.” The Temix Companies are a 50-outlet branded jewellery store chain with locations primarily in Beijing, Shanghai and Ningbo. Of the 50 outlets, 7 are stand alone stores and 43 are store counters within department stores.
• They paid approximately $11.7 million and 1.08 million shares for the Temix company, it’s inventories and intellectual property [10-K p27]
• In 2009 they’re planning to open 10-20 retail counters in department stores and 1-3 retail stores.

3) New products

• Like platinum, diamonds, and gemstones. These products have lower turnover (thereby needing more working capital) but higher margins.

4) Flexibility and responsiveness

• The production lead time of platinum products, starting from purchase of raw materials and ending with finished products, is about six to eight days, while the lead time for gold products is about two to four days. Lead-time also varies on the complexity of production and design of our products. As such, we anticipate that more working capital will be needed to support this shift of product mix. [10-K p26]

5) Economies of scale

• We have a large-scale production base that includes a modern factory of more than 53,000 square feet, a dedicated senior design team, and approximately 805 company-trained production workers. In the first quarter of 2008, we analysed and refined our production procedures to increase efficiency and reduced the number of trained workers by approximately 15%. We periodically review and analyse our production procedures and new technologies to maintain or enhance our production efficiencies. We are in the process of negotiating a program to commence research for new production technology with reputable university in China. Since 2003, we have held an ISO 9001 accreditation, which is an international standard of quality [10-K p5]
• Of coarse, being such a large scale producer, there are economies in sales and marketing, as well as in design and purchasing (being a full member of the Shanghai Gold Exchange), but there is competition that is significantly larger still.

Cheap, how cheap exactly?

• $56.57 million in cash
• $194.849 in assets
• $58.02 million in liabilities
• p/e of 4
• Peg ratio of 0.18
• While earnings growth has been quite remarkable:
• 2004: $0.34
• 2005: $0.48
• 2006: $0.51
• 2007: $0.96
• 2008: $1.32

That’s 388% growth in five years. Over the same period, sales grew from $56,765 million (2004) to $367,605 million (2008), that’s a 648% growth rate. You’ll have to agree, this is impressive.

It’s also good to know that insiders own half of the company, and institutional investors another significant slice (28%). Another very positive element is that analysts have been consistently too conservative, the company has been able to beat expectations again and again. Consensus view is a 10% growth in profit this year (from $1.32 to $1.44 per share), but that’s quite impressive against considerable headwind and could it be that analysts are too conservative again?

Anything wrong?

It’s so cheap, one is almost bound to think there is something wrong with it. If there is, we haven’t found it, and it’s not the first heavily undervalued small Chinese company we feature here (we’ve featured EFUT here as well).

Seasonality of sales (hardly surprising) and some inventory risks (they’ve started with hedging on the futures market in 2007), they’re even listing a possible outbreak of the Avian flue as one of the business risks in their year-end report. They’re not involved in any legal proceedings either, no recent sales of unregistered securities.

They were not mentioned in a famous Barron’s article about Chinese companies with dubious accounting practices

One possible worry are the increasing accounts receivable:

• At December 31, 2008, we had working capital of $129.4 million and no long-term liabilities. Except for cash and cash equivalents, a majority of our net working capital consisted of inventories and accounts receivable, both of which increased by 50% and 210%, respectively
• The increase in accounts receivable was attributable to a substantial increase in revenue generated in November and December, which is the beginning of our traditional peak season, and extending credit terms to some of our customers with high credit standings. We typically offer certain of our customers 30-days credit terms for payment. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments [10-K p.35]

They had outstanding short-term notes payables with banks in an aggregate amount of $21.9 million that are due and payable on dates between January 2009 and June 2009. Our loans are secured by inventory, real properties owned by our affiliated companies and/or guaranteed by our affiliates and our controlling stockholder [10-K p.35]

Another possible negative is negative cash from operations:

• At December 31, 2008, we had cash and cash equivalents of approximately $56.6 million and retained earnings of approximately $44.7 million. However, net cash used for operating activities for the year ended December 31, 2008 was approximately $8.0 million, and there is no guarantee that we be able to generate positive cash flow from operations for the year ending December [10-K p36]
• Despite having an operating margin of 9.07%, which point to expansion and a greater need for working capital, so it’s not likely that this is a significant problem either.

All in all, we don’t see much reason to worry, and without that, this company really does seem to be very cheap. Just as eFuture, it’s one of those small companies that lies dormant for a long time, only to move significantly on news or a big buyer. Today they can be bought for just over $5. That seems a very good deal to us..